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Canacol Energy: 42% FFO Jump, Poised To Grow Further

(Seeking Alpha, Vasily Zyryanov, 24.May.2019) — Canacol Energy, Toronto-listed and Colombia-focused natural gas producer, has recently presented its Q1 results and impressed investors with robust revenue and a 42% funds from operations increase. Importantly, that surge in cash flow and sales is just the very beginning of a much more spectacular growth story. In June 2019, as it was promised in the corporate presentation, gas production of the company will surge 65% to ~215 mmcf/d (roughly 37,996 boepd) as a result of the Promigas pipeline expansion between Jobo and Cartagena. What is more, it has the potential to produce up to 330 mmcf/d in the medium term. The sell-side analysts in the cohort compiled by Seeking Alpha Essential predict share price to equal $4.62, which is nearly 1.5x higher than the current $2.95. But is the loss-making company with a heavy debt burden literally so brilliant that analysts express phenomenally bullish sentiment?

The
top line

Canacol
Energy is Colombia’s largest independent natural gas producer focused on the
Llanos and Lower Magdalena Basins. Its current business strategy and capital
allocation priorities were calibrated according to the hypothesis that gas
demand in the country would inevitably gallop ahead, while supply from
Canacol’s competitors would gradually come down, by around 12% yearly. At the
moment, its key rival is Chevron, an integrated energy mammoth, which has been
the largest supplier to the Caribbean coast for more than 30 years and provided
nearly 50% of gas, according to Canacol’s data (see p. 4).
However, its offshore Chuchupa field in the Guajira area is depleting, putting
the sustainability of supply under question and providing opportunities to
Canacol, which “is replacing Chevron as the largest supplier of gas to
the Caribbean coast.” CNNEF projects an ~3% (YoY) natural gas demand
growth in the coastal part of the country. According to the International Monetary Fund,
Colombia’s 2019 Real GDP is expected to increase by 3.5%, which indicates that
energy needs will likely mirror the overall economic development, and Canacol’s
optimism has its rationale.

Here
it is worth briefly noting that Colombia still shuns hydraulic fracturing,
which could nearly triple the country’s oil & gas reserves and ease the gas
supply concerns. In March 2019, Canacol’s and ConocoPhillips’ environmental licensing
requests for fracking projects were shelved
by the authorities. To rewind, the companies have two unconventional oil
exploration licenses in the Magdalena Basin, VMM 2 and VMM 3. So, Colombia is
not about to follow the path of the United Arab Emirates, which have decided to
utilize colossal unconventional sour gas resources and attract IOCs to
commercialize them in order to cut dependence on Qatar’s imports (I have
touched upon that matter in the article “Total,
ADNOC, And Unconventional Gas Play”). Hence, in the medium
term, the country’s demand will likely be met solely through LNG and
conventional piped gas. So, as a piped gas supplier, Canacol has all the
chances to reap benefits from galloping demand.

To
fully benefit from favorable market changes, the firm had to pour funds into
capex to bolster reserves and develop the necessary infrastructure. It used
different sources of funds to finance growth, both debt and equity. It is quite
clear that the company used proceeds more than efficiently, as since 2013 its
2P reserves have been increased 7.2x. The flipside is a lofty net debt/EBITDA
ratio (3.5x) and burdensome interest expense, which makes operations riskier
and puts pressure on cash flow generation. Massive debt (Debt/Equity ratio of
1.7x) could easily ruin the growth story of any company, so, despite
anticipated and secured production leap, potential investors probably stay on
the sidelines. BB- grade from Fitch and B1 from Moody’s (see p. 15)
perhaps make some investors avoid the company’s equity as too risky. Another
matter worth emphasizing is that costly debt increases WACC (Weighted Average
Cost of Capital) and thus pummels the intrinsic value. Hence, when a company
manages to bring borrowings to the lowest level possible and reduce the cost of
debt, its fair or hidden value based on discounted cash flows increases. I hope
with production jump and EBITDAX surge, Canacol will manage to ameliorate
capital structure and alleviate the debt burden. I reckon that when the firm
ultimately unlocks the potential hidden in the asset base it amassed, the debt
will come down quickly. That is essential to attract investors and prop up the
share price.

A
brief look at 1Q19

In
1Q19 Canacol’s realized contractual sales jumped 15%, bolstering FFO per share
by 42%. The company not only increased the top line, but also enhanced
operating efficiency, bringing opex down by 29% QoQ. As a result, EBITDAX rose
18% compared to 1Q18. Yet, negative FCFE is a clearly disenchanting matter.
$25.2 million generated by operations were not enough to cover investments in
PP&E of $25.15 million and expenditures on E&E of $2.49 million.
Besides, the company paid $7.4 million as net financing expense, and $1.15
million were used to cover lease principal payments. In sum, levered FCF was
profoundly negative, as in 2018, and $1.15 million share buyback in Q1 was not
the best decision. However, despite uninspiring LTM cash flow, I expect that
sales and EBITDAX growth will help Canacol to turn FCF positive in FY19.

As
far as both the bottom line and FCF are negative, standard profitability
measures as ROE and net margin are irrelevant. However, we could compute Return
on Total Capital, the metric that utilizes EBIT or operating income in the
nominator. It appears
that ROTC is quite decent, 8.28%, while the sector median is 3.74%. What is
more, I expect profitability to improve further in H2 2019 as a direct
consequence of higher gas sales and low opex.

Valuation

Canacol
is loss making and FCF negative at the moment, so standard valuation metrics as
P/E, PEG, FCF yield are irrelevant and useless. Fortunately, despite massive
leverage, its net worth is positive, and we could benchmark the Price/Book
ratio against the Canadian and US market medians. It appears that compared to
the US market, Canacol is substantially overpriced, as far as its P/B of 2.5x
is well above the market median of 1.84x; at the same time, Canadian stocks’
median P/B is 1.44x. The only justification of such lofty valuation is
anticipated stellar revenue growth.

Apart
from comparison to the broad market, it is worth taking into account the
valuation of comparables. Toronto-listed Frontera Energy and London-listed
Amerisur Resources, in my view, are the closest peers of the company, because
they are focused on E&P operations in Colombia (Frontera also has a
footprint in Peru), though they produce primarily oil. Frontera has
EV/Production ratio of ~18.2x, Amerisur’s ratio is ~30x. Contrarily, Canacol’s
valuation is higher, 39.61x. So, it is relatively overpriced in the peer group
due to stellar growth prospects.

I
also reckon that Australian Cooper Energy, which I covered in October 2018, is
akin to Canacol despite different regions of operations. Their prospects and
natural gas-focused strategies are pivotal similarities. The Sole gas project
is an apparent boon of Cooper, and it will propel revenue growth this year.
Unfortunately, COPJF and CNNEF are loss making, so the P/B ratio might be used
instead of earnings yield. Cooper currently trades at ~2.1x Price/Book, while
CNNEF P/B is ~2.5x. So, as the natural gas stock with hefty growth prospects,
Canacol looks reasonably priced.

Final
thoughts

Canacol
operates in a favorable environment with bright demand growth prospects. It has
poured gargantuan funds into exploration, appraisal, and development, and now
is poised to reap benefits utilizing amassed asset base. Though the stock’s
Quant rating provided
by Seeking Alpha Essential, which is exceptionally helpful in equity research
routine, is close to “Neutral” now, I believe that sell-side analysts
who express bullish sentiment are right. Yet, I suppose the market needs time
to realize the hidden value of the company, while leverage should definitely go
down, as Fitch’s BB- rating might hinder to attract new investors’ attention.

Unfortunately,
Canacol is not a dividend payer, which is not coincidental, as capex coverage
and debt servicing are the essential matters with the highest priority. Yet, if
anticipated EBITDAX and cash flow surge comes true in 2019-2020, I suppose the
firm might consider an option to reward shareowners.